The guest commentary below was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst.
Sisyphus is a figure from Greek mythology.
For sins in mortal life, he was punished by Zeus to forever roll a boulder up a hill in the depths of Hades, only to see it to roll down again. The Federal Open Market Committee is essentially trapped in the torment of Sisyphus. They keep trying to add liquidity to the domestic US money markets, only to see it leak out into the vast offshore market for dollar funding.
This week the FOMC announced that the minimum size of its overnight repurchase-agreement operations will rise to $120 billion, from what had been at least $75 billion. Long-term repo operations will rise from a minimum daily offering size of $35 billion and go up to $45 billion in interventions scheduled for Thursday and Oct. 29. The longer-term repo operations are scheduled to carry over into November, but you can expect the operations to be extended into next year.
Trouble is that these larger operations are unlikely to be effective. Why? Because the US and foreign banks that hold liquidity have no incentive to make this liquidity available to domestic borrowers in the US. Indeed, the entire intellectual construct that allowed the FOMC to think in 2018 that they could actually raise interest rates is shown to be a complete fallacy.
“Everyone in the markets focused on repo problem as technical, given the competition for funding from T-bills/reserves,” notes Ralph Delguidice at Pavilion Global Markets. “Fed asset swap ‘not QE’ designed to force cash out of T-bills into general collateral (GC), but is now failing as sellers of those Bills (foreign official mostly) park cash in reverse repurchase (RRPs) instead. But problem isn’t cash not flowing UP to repo, it is cash not flowing DOWN to repo.”
A number of analysts such as George Selgin at Cato Institute have rightly focused on the “leakage” in the Fed’s “floor” system for fed funds, but the offshore dimension may be a more significant factor thwarting the efficacy of Fed policy. It's about the spread everybody. Duh.
The fact that regulatory policies such as Dodd-Frank and Basel III are blocking the movement of funding is easily understood by the markets (but not Massachusetts Senator Elizabeth Warren, it seems). Most of the TBTF/G-SIB banks must shrink going into year end to avoid a G-SIB capital surcharge penalty. Last December’s liquidity crisis was a function of JPMorgan (JPM) and other large banks backing away from the short-term markets. Thanks Elizabeth!
With the level of bank reserves now lower than a year ago, the rocks in the proverbial stream are starting to appear. The Fed is trying to address their error by dumping more reserves back into the system via QE and repo, but the “liquidity” is running out of a hole in the bucket thanks to the spread between what a cash provider earns on repo – say +75bps over LIBOR in Treasury and agency repo – and the higher yields available in the $10 trillion market for currency swaps. Call it 2%.
Delguidice believes that as US interest rates have risen, demand in the $10 trillion market for currency swaps (aka “Eurodollars”) has soared, proving an impossible situation for the Fed as it tries to manage the 1.75-2.0% target range for Fed funds.
“FX-swaps are a ten trillion-dollar market and are functionally equivalent to a repo to lenders of USD (most of the time), only with higher rates reflected by the basis,” says Delguidice. “They also receive derivative treatment on balance sheets, unlike REPO, so dealers would MUCH rather do them. You only have count MTMs in the capital charge, but unlike repo they MUST be physically settled when they mature. They cannot just be rolled over.”
Many sellers of T-bills are non-US banks. Many of these then take the cash and go into the RRP market away from the Fed. These banks get UST collateral that they can hypothecate to, you guessed it, access dollar liquidity. Many of these non-US banks in China and other Asian nations are profoundly short-dollars and hold trillions in dollar loan assets. Important, you cannot hypothecate the RRPs at the Fed. See BIS paper here on the "missing debt" parked offshore for your happy reading this weekend.
Bottom line is that the rate paid and earned for RPs and RRPs is important, but the actual flow of cash vs "excess reserves" measured by our friends at the Fed is another matter. The Fed is uniquely ill-equipped to deal with such tactical issues. The Fed's balance sheet may grow, but the supply of cash liquidity in the broad market may not. The liquidity that the Fed is adding may not "trickle down" to the GCF and fed funds markets outside the primary dealers.
Indeed, each day there is a 20-30 basis point differential between what the Fed charges primary dealers (~1.85% today and the rest of the market (~2.05%). This effective rate differential is likely to widen as the year comes to a close. Truth is, not only has the FOMC lost control of the Fed’s balance sheet to the financial markets, but the offshore Eurodollar market may force the FOMC to collapse US rates to eliminate the rate differential or "spread" between domestic fed funds and repo and the effective negative cost of funds offshore.
The Fed and prudential regulators could take a lot of pressure off the money markets by adjusting the G-SIB capital surcharge and a couple of other relatively minor tweaks to the bank regulatory environment, but Senator Warren is having none of it.
“So now the worst single thing that can possibly happen has happened,” notes Delguidice. “Elizabeth Warren wants to complicate what could have been a simple and straightforward hostage negotiation with JPM’s Jamie Dimon over regulatory relief and the eventual Fed acquisition of the UST he is having increasing difficulty funding in the GC markets on his balance sheet.”
Remember, the TBTF/G-SIBs will again be shrinking their balance sheets going into year-end thanks to Basel III/IV and Dodd-Frank. Now you understand why the Fed just doubled down on adding repo liquidity to the markets, but it may not work. And a socialist presidential candidate named Elizabeth Warren is perfectly willing to crash the US financial markets to advance her never ending quest for celebrity and fame.
Fed Chairman Jay Powell is Sisyphus. Elizabeth Warren thinks she is Zeus. This will not end well. Good weekend.
EDITOR'S NOTE
This Hedgeye Guest Contributor piece was written by Christopher Whalen, author of the book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. This piece does not necessarily reflect the opinion of Hedgeye.